Economic Measures of Profitability. Lecture notes for PET 472 Spring 2013 Prepared by: Thomas W. Engler, Ph.D., P.E.
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1 Economic Measures of Profitability Lecture notes for PET 472 Spring 2013 Prepared by: Thomas W. Engler, Ph.D., P.E.
2 Measures Measures that ignore time value of money net profit payout time return on investment, ROI Measures that recognize the time value of money Internal rate of return, IRR Net present value, NPV Discounted return on investment, DROI
3 Profit cashflow = Revenues royalty-expenses taxes + depreciation Revenues = oil production*oil price + gas production*gas price Gross = refers to 100%, e.g., Working Interest (WI) Net = refers to revenue less royalties, Net Revenue Interest (NRI) Expenses = operating expenses Taxes 1. Severance and ad valorem based on production ($/bbl) or net revenue (%) 2. Federal applied to operating income Depreciation A noncash expense that recognizes a decrease in a fixed asset s value due to wear & tear Net income = Revenues royalty-expenses taxes Profit = cashflow - investment Strengths Simple, unambiguous Weakness Does not inform analyst to the size of the investment or timing of the cashflow
4 Simplified Example investment = EUR = Future expenditures = W.I. = effective annual interest rate = Type of discounting = $ 268,600 completed well $ 200,000 dry hole BO Mcf $ 10,000 year 3 pumping unit $ 20,000 year 5 workover 100% 10% mid-year Annual oil Annual Future Net Cumulative Payout Discount DCF Year production net income* expenditures cash flow cashflow time factor BO $ $ $ $ yrs 10% $ 0 $ (268,600) $ (268,600) $ (135,700) $ 126, $ (2,800) $ 115, $ 94, $ 76, $ 164, $ 49, $ 187, $ 15, $ 216, $ 16, $ 232, $ 8, $ 241, $ 4, $ 247, $ 2, $ 248, $ 768 sum = $ 248, $ 148,441 * Annual net income = annual gross revenue-royalty-taxes-operating expenses
5 Payout Length of time until investment is paid in full n AFIT Cashflow{$/ yr} Capital investment {$} i 1 Strengths Simple, unambiguous Measures an impact on liquidity Weakness Considers cashflow to a point Difficult for projects with large abandonment costs or rate acceleration projects
6 Return on Investment, ROI A measure of the total profitability ROI Cumulative AFITCashflow Investment Profitable projects, ROI > 0 Alternative, Benefits-to-cost ratio BCR Cumulative AFITCashflow Investment Investment Strengths Simple Recognizes a profit in relation to investment size Can also use discounted cashflows, DROI Weakness Continuing investments Profitable projects, BCR > 1
7 Simplified Example Annual oil Annual Future Net Cumulative Payout Discount DCF Year production net income* expenditures cash flow cashflow time factor BO $ $ $ $ yrs 10% $ 0 $ (268,600) $ (268,600) $ (135,700) $ 126, $ (2,800) $ 115, $ 94, $ 76, $ 164, $ 49, $ 187, $ 15, $ 216, $ 16, $ 232, $ 8, $ 241, $ 4, $ 247, $ 2, $ 248, $ 768 sum = $ 248, $ 148,441 * Annual net income = annual gross revenue-royalty-taxes-operating expenses Profit = $ 248,900 Payout time = 2.03 yrs ROI = 0.93 BCF = 1.93
8 Present Value, PV A measure of the present value of future cash flows: PV=FV(1+i) -t Discount factor = (1+i) -t Characteristics Project NPV is sum of cashflows Not trial and error NPV has features of IRR regarding time value of money Suitable for probabilities NPV = 0 investment yields a rate of return = discount rate Does not indicate size of cashflows Discount rate can vary for a given project PV concept works with (-) numbers Specifying discount rate is difficult FV future value i effective annual discount rate Mid-year discounting = (1+i) -t+1/2
9 DCF, $M Economics Rate of Return, IRR The discount rate such that NPV = y = x IRR Characteristics Includes time value of money trial and error Independent of magnitude of cashflows Cannot calculate IRR if cashflows all (+) or (-) Cashflows received early in the project are weighted more heavily Sensitive to initial investment Convenient % to compare with corporate objectives Reinvestment assumption-all cashflows received will be reinvested at the computed rate of return Competing investments have different (IRR) time values of money, thus IRR may not be a realistic parameter to assess rank Cannot use probability Can be computed BFIT and AFIT % 10% 20% 30% 40% 50% 60% Discount rate, %
10 DCF, $M Economics Simplified Example Annual oil Annual Future Net Cumulative Payout Discount DCF Year production net income* expenditures cash flow cashflow time factor BO $ $ $ $ yrs 10% $ 0 $ (268,600) $ (268,600) $ (135,700) $ 126, $ (2,800) $ 115, $ 94, $ 76, $ 164, $ 49, $ 187, $ 15, $ 216, $ 16, $ 232, $ 8, $ 241, $ 4, $ 247, $ 2, $ 248, $ 768 sum = $ 248, $ 148,441 * Annual net income = annual gross revenue-royalty-taxes-operating expenses i = $ 148,441 $ 148,441 Internal rate of return (IRR) i DCF % $M 10% % % 34.8 IRR = 41% y = x % 10% 20% 30% 40% 50% 60% Discount rate, % DROI = 0.553
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